Dollar-Denominated Corporate Time Bomb Set to Blow

Hot Money Flees Mexico.

Emerging economies around the world are already feeling the first pangs of withdrawal as fast yield-chasing investors send their funds back to the U.S. in anticipation of higher Treasury yields and a further appreciating dollar.

In Mexico, the central bank has just published its balance of payments data for the third quarter, 2015. The results do not make for pretty reading.

Early Signs of a Stampede

Net portfolio investment – the total amount of foreign money spent on Mexican financial assets – clocked in at a paltry $933 million, down from $4.47 billion during the same quarter last year. That’s a 79% drop. It was also Mexico’s fifth successive quarterly decline and the lowest level recorded since 2002. Although the rout was across the board, it was particularly pronounced in the private sector which suffered a $241 million net outflow of funds.

Interestingly, while portfolio investment stagnated, foreign direct investment (FDI) flourished, growing by 57.6% in the first nine months of 2015. In other words, those who are investing for the long haul continue plowing funds into Mexico. Which is wonderful news — in the long term! The problem is that investors who are after the quickest of monetary fixes are frantically moving their money out. And that is bad news in the short term! Crises are made of this phenomenon.

And right now, with monetary pressures building around the globe, it’s the short term that counts.

Since the U.S. Federal Reserve alighted on its madcap scheme to flood the global economy with dirt cheap, easy-come-easy-go dollars, high-yield seeking “investments” have poured into emerging markets. Much of the money ended up in Mexico, one of comparatively few Latin American economies to have completely liberalized its financial sector.

If the Fed were to begin raising interest rates again, which it keeps threatening it might eventually do, it would significantly tamp down on investor appetite for risky, high-yield emerging market assets. The merest prospect of a quarter-point raise is enough to send junkie-like convulsions through the investment community. As the IMF warned in its Article IV consultation with Mexican authorities, “a surge in financial market volatility, triggered for example by a disorderly normalization of U.S. monetary policy, could lead to a reversal of capital flows and an increase in risk premia.”

If that were to happen, the consequences could be dire, not only for Mexico but for the broader Latin American economy.

The Next Tequila Crisis?

The last time Mexico suffered a similar fate was during the 1994 Tequila Crisis when billions of dollars of hot money fled the country northward in the pursuit of rising U.S. interest rates. Then, much as now, the financial sectors of both Mexico and the U.S. were unprepared for what was to come. In the end, Mexico’s banks were rescued by a gargantuan bailout in order to keep Wall Street’s biggest investment banks whole [my take, as seen in 2013: The Tequila Crisis: A Prelude to Europe’s Economic Storm].

There are major differences between Mexico now and Mexico then. In certain ways, Mexico’s economy is better prepared for a category-five economic and financial storm than it was back then.

In 1994 Mexico’s peso was pegged to the dollar; now there are more flexible arrangements in place, which means that the Bank of Mexico has more options available and (at least in theory) does not need to deplete its hard currency reserves in a futile bid to preserve the dollar peg. That hasn’t stopped Mexico’s central bank from burning through close to $20 billion (of $196 billion) of its currency reserves this year in a vain attempt to steady the crumbling peso. The reserves are now at their lowest point since 2013.

Another important point in Mexico’s favor is that unlike Brazil, Argentina, Venezuela and other countries in Latin America, not to mention the Mexico of yore, it faces limited (and for the moment largely containable) inflationary pressures. Despite a heavily depreciated peso, inflation remains at a historic low of 2.3%.

A Ticking Time Bomb

That’s not to say that the economy is out of the woods – not by a long shot. Like many emerging economies, Mexico has a ticking time bomb in its midst: corporate debt. In the last few years, Mexican corporations have been issuing dirt cheap dollar-denominated debt as if there were no tomorrow. But as the peso falls against the dollar, that dollar-denominated debt becomes increasingly difficult to service, especially if most of your operating income is peso-denominated. A recipe for a debt crisis.

Worse still, out of fear that the Fed may be about to take away the ZIRP punch bowl, some of Mexico’s biggest corporations are embarking on one last dollar borrowing binge – and not necessarily for the purpose of productive investment. As Agustín Carstens, governor of the Bank of Mexico and chairman of the IMF’s International Monetary and Financial Committee, recently warned, despite the unprecedented monetary stimulus of recent years, corporate investment actually fell in emerging and advanced economies by 2.5% of GDP:

The crux of the matter is that financial risk-taking has been far more responsive to unconventional monetary policies than real risk-taking has been…

The flows promoted by excess global liquidity created a sense of exuberance which in turn generated mispricing in some assets in many emerging markets and meaningful exchange rate appreciations; and opened the door for potential sovereign capital-flow reversals.

For a senior central banking insider, Carstens is uncharacteristically vocal about the threat posed to emerging economies like Mexico by the flood of dollars, unleashed by the Fed’s policies, and their sudden disappearance. But he will probably be powerless to prevent or even mitigate their impact on the Mexico. By Don Quijones,Raging Bull-Shit.

10 comments for “Dollar-Denominated Corporate Time Bomb Set to Blow”

Sorry, I didn’t catch that either when I posted Don’s article (though I should have). Corrections made. All numbers in the paragraph should be – and are now – in USD. Thanks for pointing it out.

BoyfromTottenham

Nov 30, 2015 at 2:48 am

Great article as usual Don, but is this a typo (“Euro 241 Million” should be Billion)?:

“Although the rout was across the board, it was particularly pronounced in the private sector which suffered a €241 million net outflow of funds.”

Don Quijones

Nov 30, 2015 at 6:39 am

Thanks BFT for your kind remark.

In this case no typo: millions not billions (of dollars, not euros — mea culpa, MD), though the reversal in the trend is worth billions of dollars. In other words a few years ago billions of dollars were pouring into Mexico and other emerging markets each quarter to chase high-yield, high risk assets. Now more money is coming out than going in.

When people start selling high-yield, high-risk assets — the sort of assets that only Fed-backed investors would buy — in large enough numbers, new buyers can be very hard to come by to plug the fast-forming holes. That’s when the real problems begin.

Keith

Nov 30, 2015 at 2:49 am

A world without capital controls seems like an insanely unstable place.

Mark

Nov 30, 2015 at 9:13 am

I think you are completely wrong on that statement.
All capital is well controlled in hands of 1%, it was and it will stay like that.

Nicko

Nov 30, 2015 at 10:47 am

More-so than ever, 80 people now have a combined wealth greater than the poorest 50% on the planet.

NotSoSure

Nov 30, 2015 at 12:27 pm

I am still waiting for the first emerging market implosion. If I am the governor of the CB of Mexico, I’d call Yellen direct and apply for TBTF status pronto. Problem solved.

d'Cynic

Dec 1, 2015 at 6:58 pm

Actually Mexico is TBTF.
The first Mexican crisis started the ball rolling.
Greenspan arranged a loan to Mexico to pay US investors in full.
The second chapter was the Russian crisis and LTCM. The fool proof algorithms of LTCM predicted that an event like that would occur on the timescale of the age of the universe (end of commercial).
Again a loan was arranged, and the crisis petered out.
That made Greenspan enthused; the market can solve everything on it’s own without regulation – with a skillful nudge from the CB.
Each successive crisis/bubble was met with another bailout/easing, and led to the one we live in.